Saturday, May 14, 2011

The Mechanics of Greek Default

For those of you thinking about how a (probably inevitable) Greek default might work, take a look at Barry Eichengreen's piece this week at Project Syndicate. I can't think of any economist more knowledgeable about issues of international finance than Eichengreen, so when he describes the mechanics of default, it's worth paying close attention.

BERKELEY – Financial markets are increasingly certain that a Greek debt restructuring is coming, and European policymakers fear the worst. ...But there is also a best-case scenario, where Greek debt is restructured in a way that doesn’t threaten the banking system.

The simplest way to achieve this would be to require banks exposed to southern European debt to raise more capital. ...But Europe’s track record does not inspire confidence that the next round of tests will be much more rigorous than the last. Raising capital is expensive. This encourages stakeholders to deny, rather than acknowledge, problems.

Plan B would extend the maturity of Greece’s debt. ...But this would still leave Greece with an impossibly heavy debt burden. A reduction in that burden of 40%, whether in the form of reduced interest or principal, is needed to bring the debt-to-GDP ratio to below 100%, a level at which the country has some hope of meeting its payment obligations.

Fortunately, there is another way: emulate the Brady Plan, under which commercial banks, together with the United States, the International Monetary Fund, and the Paris Club of sovereign creditors, restructured and took haircuts on the debt of Latin American and Eastern European governments at the end of the 1980’s. Two of my Northern California neighbors, Peter Allen and Gary Evans – both veterans of the Brady Plan – have explained how a similar plan could be implemented today...

...So, rather than worrying that they might be approaching a Lehman Brothers moment, European policymakers would be better off designing a Greek debt deal tailored, like the Brady Plan, to avoid this fate.

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The Street Light is written by economist Kash Mansori, who works as an economic consultant (though views expressed here are entirely his own), writes whenever he can in his spare time, and teaches a bit here and there. You can contact him by writing to the gmail account streetlightblog. (More about Kash.)